November 17, 2011 What's in a Name? The Volcker Rule's Impact on ABS Issuers that are Covered Funds. Contents Speed Read 2 Why the Volcker Rule Matters to ABS Issuers 3 What's in a Name? 4 Sponsorship and Ownership 5 Limited Exemption for Loan Securitizations 6 Super 23A and You 7 Conclusion 8 Key Contacts 9 www.allenovery.com 1
Speed Read The "Volcker Rule" enacted into law by Section 619 (Section 619) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) includes a provision intended to preserve the ability of banking entities to continue conducting loan securitizations. However, the proposed rules released on October 11, 2011 (the Proposed Rules) by four federal agencies (the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System (the Board) and the Office of the Comptroller of the Currency (collectively, the Agencies)) for public comment still leave in question the fate of many securitization products. In addition to prohibiting proprietary trading by banking entities, the Proposed Rules would prohibit banking entities from owning or sponsoring covered funds and from entering into certain transactions with covered funds. A covered fund would be any issuer which would be required to be registered as an investment company, as defined in the US Investment Company Act of 1940, as amended (the ICA), but for the exclusion from registration as an investment company provided by either Section 3(c)(1) or Section 3(c)(7) of the ICA (respectively, Section 3(c)(1) and Section 3(c)(7)). As participants in the securitization industry are fully aware, there are many issuers of assetbacked securities (ABS) affiliated with banking entities which rely on such exclusion. ABS issuers established by non-us banks are likely to be impacted particularly severely, since they do not generally rely on Rule 3a-7 under the ICA (Rule 3a-7) because off-shore securitizations by non-us banks often do not use a US trustee, which is a requirement for reliance upon Rule 3a-7. There are additional requirements under Rule 3a- 7 which may result in the rule being unavailable to ABS issuers utilizing certain structural features. Moreover, ABS issuers relying on the exclusion from registration provided by Section 3(c)(5) of the ICA (Section 3(c)(5)) may, in the future, be unable to rely on that exclusion as a result of possible amendments to the ICA discussed, but not proposed, in an advanced notice of proposed rule making, 1 If amendments that would make Section 3(c)(5) unavailable to ABS issuers are proposed and finalized, some ABS issuers might need to rely on Section 3(c)(1) or Section 3(c)(7) even if it means they are covered funds. Although the Agencies attempted to respect Section 619's mandate that loan securitizations continue to be permitted, this exemption has been narrowly crafted in the Proposed Rules, resulting in an uncertain future for such common securitization products as asset-backed commercial paper (ABCP). If amendments to Section 3(c)(5) prohibit securitization issuers from relying on that exclusion, certain issuers of residential mortgagebacked securities, including certain United Kingdom issuers, could also become covered funds. 2 www.allenovery.com
What's in a Name? The Volcker Rule's Impact on ABS Issuers that are Covered Funds Why the Volcker Rule Matters to ABS Issuers Key features of the Proposed Rules would prohibit a banking entity from: (1) engaging in proprietary trading, subject to certain exemptions for, among other things, permitted underwriting and market-making related activities and permitted risk-mitigating hedging activities; and (2) (a) acquiring or retaining an ownership interest in, or sponsoring, a covered fund, subject to certain exemptions for, among other things, loan securitizations, and (b) entering into "covered transactions" with a covered fund. The Proposed Rules' prohibition on proprietary trading is so broadly cast that it was necessary to include in the Proposed Rules an exemption for certain underwriting and market-making activities. Although many readers might be surprised that underwriting activities would be included in a prohibition on proprietary trading and therefore need an exemption, the failure to satisfy the requirements of the underwriting exemption would result in those underwriting activities falling within the scope of the Proposed Rules' prohibition on proprietary trading. Additionally, marketmaking activities and risk-mitigating hedging activities would each need to be conducted in a specified manner to fall within the applicable exemptions provided by the Proposed Rules. We have previously discussed the prohibition on proprietary trading contained in the Proposed Rules and the foregoing exemptions in our prior ealerts, on the Proposed Rules and on proprietary trading in derivatives, and have also compared the market-making exemptions and risk-mitigating hedging exemptions contained in the conflict of interest notice of proposed rulemaking and the Proposed Rules. We will discuss the impact of the "Volcker Rule" on structured products such as repack vehicles and collateralized loan obligations (CLOs) in a future ealert. In addition to prohibiting proprietary trading activities by banking entities, the Proposed Rules will prohibit "banking entities" (as defined in the Proposed Rules) from acquiring or retaining an ownership interest in covered funds, sponsoring covered funds and entering into covered transactions with covered funds. In a prior ealert we discussed the impact of the prohibition on bank-affiliated asset managers. The Proposed Rules do include an exemption which would permit a banking entity to acquire and retain an ownership interest in a covered fund to the extent the banking entity is required by the Dodd-Frank Act to retain credit risk in connection with an ABS issuance (a notice of proposed rule-making regarding credit risk retention in ABS transactions was previously proposed and discussed in a prior article). We have likewise previously discussed the effects of the ban on sponsoring or investing in certain funds imposed on foreign banks with US branches, agencies or subsidiaries and the affiliates of such foreign banks and the manner by which the Proposed Rules seek to implement the foreign funds exemption in respect of such foreign banks and their affiliates (see Allen & Overy s previous ealerts Foreign Banks Part I and Foreign Banks Part II). www.allenovery.com 3
What's in a Name? Section 619 broadly defines a covered fund as, among other things, any issuer which would be required to be registered as an investment company, as defined in the ICA, but for the exclusion from registration as an investment company provided by either Section 3(c)(1) or Section 3(c)(7) (commonly referred to as the "100 holder" and "qualified purchaser" exclusion, respectively). Although the covered fund definition was targeted at hedge funds and private equity funds, Section 3(c)(1) and Section 3(c)(7) are relied upon as exclusions from registration as investment companies by many issuers (including many securitization issuers) in addition to hedge funds and private equity funds. As we have noted in our initial ealert on the Proposed Rules, if the issuer is determined to be a covered fund, the Proposed Rules would prohibit a banking entity from: (i) acquiring or retaining an "ownership interest" in, or sponsoring, the covered fund, subject to certain limited exemptions, and (ii) entering into "covered transactions" with the covered fund if it is acting as sponsor, investment manager or investment advisor (and require permitted transaction to be on market terms). The Proposed Rules define a banking entity to include (i) any insured depository institution, (ii) any company that controls an insured depository institution, (iii) any company treated as a bank holding company for purposes of the International Banking Act of 1978 (which would include foreign banking organizations with branches or agencies in the United States), and (iv) any affiliate or subsidiary of any of the foregoing. The Proposed Rules clarify, however, that the term "banking entity" does not include any affiliate or subsidiary of a banking entity if that affiliate or subsidiary is a covered fund or an entity controlled by a covered fund. But banking entities with affiliates or subsidiaries which are ABS issuers should note that, if such affiliate or subsidiary is not a covered fund, it will probably be a banking entity under the Proposed Rules. Under the Proposed Rules, an affiliate of a banking entity is any entity that controls, is controlled by, or is under common control with the banking entity. A subsidiary of a banking entity under the Proposed Rules is any entity 25% or more of whose voting shares are directly or indirectly controlled by the banking entity, or the election of a majority of whose directors are controlled by the banking entity, or for which the banking entity exerts a controlling influence over the policies or management. As a banking entity, the ABS issuer would be required to comply with the Proposed Rules' provisions relating to banking entities, including the limitations on proprietary trading, limitations on investments, prohibition on covered transactions, restrictions on permitted transactions and satisfaction of compliance program, record keeping and reporting requirements. In the commentary to the Proposed Rules, the Agencies are requesting comments on whether ABS issuers would be banking entities under the Proposed Rules and, if so, whether they should be expressly excluded from the definition of banking entity. The Agencies are also requesting comments on the impact of treating ABS issuers as banking entities. Additional commentary to the Proposed Rules clarifies that covered funds are entities relying solely on either Section 3(c)(1) or Section 3(c)(7). Recognizing the nonexclusive nature of the ICA exclusions from registration, an issuer would not be a covered fund if an exclusion from registration as an investment company other than Section 3(c)(1) and Section 3(c)(7) were available to the issuer, www.allenovery.com 4
What's in a Name? The Volcker Rule's Impact on ABS Issuers that are Covered Funds even if the issuer had agreed to provisions designed to bring the issuer within the scope of either Section 3(c)(1) or Section 3(c)(7). Foreign issuers should note that foreign equivalents of any entities identified as covered funds would be covered funds even though they do not offer securities to US investors and do not need to rely upon Section 3(c)(1) or Section 3(c)(7) for an exclusion from registration as an investment company. To this point, the Agencies state in footnote 225 of the commentary to the Proposed Rules that the "Proposed Rule makes clear that any issuer, as defined in section 2(a)(22) of the [ICA], that is organized or offered outside of the United States, would qualify as a covered fund if, were it organized or offered under the laws, or offered for sale or sold to a resident, of the United States or of one or more States, it would be either: (i) [a]n investment company, as defined in the [ICA], but for section 3(c)(1) or 3(c)(7) of [the ICA]; (ii) a commodity pool; or (iii) any such similar fund as the appropriate Federal banking agencies, the SEC, and the CFTC may determine, by rule, as provided in section 13(b)(2) of the [Bank Holding Company Act (the BHC Act)]." Although the commentary to the Proposed Rules clarifies that issuers relying on Section 3(c)(5) or Rule 3a-7 will not be covered funds, a recent advanced notice of proposed rulemaking relating to possible amendment to Rule 3a-7 raised the possibility that the ICA may be amended to prohibit ABS issuers from relying on Section 3(c)(5), an exclusion which currently may be relied upon by, among others, issuers primarily holding mortgages, auto loans and credit card receivables. Most ABS issuers who rely on Section 3(c)(5) do so because they can not satisfy the requirements of Rule 3a-7 and do not want to subject themselves to the investor limitations set forth in Section 3(c)(1) and Section 3(c)(7). If Section 3(c)(5) is no longer available to issuers, those issuers would most likely need to rely upon the exclusion provided by Section 3(c)(1) or Section 3(c)(7), thereby limiting their investor base and becoming covered funds under the Proposed Rules. Sponsorship and Ownership ABS issuers will need to familiarize themselves with the Proposed Rules' expansive definitions of "sponsor" and "ownership", the latter defined to include derivatives of ownership interests. As a result, transactions which traditionally would not have been viewed as sponsorships or as creating ownership, could be prohibited sponsorship or ownership under the Proposed Rules. A sponsor is any entity which "(i) serves as a general partner, managing member, trustee or commodity pool operator of a covered fund; (ii) in any manner selects or controls (or has employees, officers, or directors, or agents who constitute) a majority of the directors, trustees, or management of a covered fund; or (iii) shares with a covered fund, for corporate, marketing, promotional, or other purposes, the same name or a variation of the same name." The commentary implies that the defined term of sponsor continues the focus on the ability to control the decision-making process and operation functions of the covered fund; and, therefore, a trustee which does not exercise investment discretion with respect to a covered fund would not be a sponsor. Interestingly, the definition is drafted for a corporate governance structure and does not incorporate the concepts applicable to a determination of a sponsor in a securitization context even though the Agencies recognize that the definition of covered fund will capture some ABS issuers. The Agencies recognize this issue and are requesting comments on whether an www.allenovery.com 5
alternative definition of sponsor, such as the Regulation AB definition, would be more appropriate for ABS issuers. An ownership interest is defined as "any equity, partnership, or other similar interest (including, without limitation, a share, equity security, warrant, option, general partnership interest, limited partnership interest, membership interest, trust certificate, or other similar interest) in a covered fund, whether voting or nonvoting, as well as any derivative of such interest," but excludes carried interest in recognition of how banking entities which act as investment advisors or commodity pool advisors to covered funds are often compensated. The definition is designed to focus on the attributes of the interest and the banking entities' exposure to economic profits and losses of the covered fund rather than the form of the interest. A debt security which exhibits "substantially the same characteristics" as an equity ownership could be considered an ownership interest because the defined term includes "other similar interests." Limited Exemption for Loan Securitizations The Proposed Rules include a loan securitization exemption which would allow a banking entity to engage in the securitization of loans by acquiring or retaining an "ownership interest" in, or sponsoring, a covered fund, provided that the only assets of such covered fund are (1) loans, (2) contractual rights or assets directly arising from those loans supporting the ABS issued by the covered fund and (3) interest rate or foreign exchange derivatives that materially relate to the terms of such loans or contractual rights or assets and are used for hedging purposes with respect to the securitization structure. The loan securitization exemption was included in the Proposed Rules to implement the mandate in Section 13(g)(2) of the BHC Act that nothing in Section 13 of the BHC Act would be construed to limit or restrict the ability of a banking entity or nonbank financial company supervised by the Board to sell or securitize loans in a manner otherwise permitted by law. The Proposed Rules define a loan as any loan, lease, extension of credit or secured or unsecured receivable but does not include ABS. The term "loan" appears broad enough to include the intercompany loan held by an issuer in certain UK mortgage-backed securitizations. However, the exclusion of ABS means that the loan securitization exemption is not available to covered fund issuers of ABCP (which typically hold ABS, but could possibly restructure their programs to hold loans to take advantage of the exemption), resecuritizations and collateralized debt obligations. Synthetic securitizations would also be unable to rely on the loan securitization exemption. The Agencies recognize that ABCP issuers will be unable to rely on the loan securitization exemption and are requesting comment as to whether the intermediate securitization should be recognized as a single securitization with the ABCP and included within the securitization of loans. It is not clear whether acquisition of permitted investments by an ABS issuer, a common aspect in ABS transactions, would cause the loan securitization exemption to be unavailable. By requiring an interest rate or foreign exchange derivative to "materially relate to the terms of such loans," the Proposed Rules quantitatively limit the derivatives permitted in a securitization of loans under the loan securitization exemption to include only those derivatives www.allenovery.com 6
What's in a Name? The Volcker Rule's Impact on ABS Issuers that are Covered Funds where the notional amount of the derivative is tied to the principal balance of the loans supporting the ABS of the issuer, either individually or in the aggregate. Additionally, the requirement that derivatives be used for hedging purposes means that they must be used solely to hedge the risk that results from a mismatch between the loans and the ABS, and would not allow the use of credit default swaps by an ABS issuer. Super 23A and You For those covered funds meeting the stringent requirements of the loan securitization exemption, the benefit of the loan securitization exemption are limited by the expansion of Sections 23A and 23B of the Federal Reserve Act under the Proposed Rules. Currently, Section 23A's effect on "covered transactions" requires only that such transactions meet certain qualitative and quantitative requirements. By contrast, the Proposed Rules would deem the covered fund to be an affiliate of a banking entity which (i) acts, directly or indirectly, as the sponsor, investment advisor, investment manager, or commodity trading advisor to such covered fund or (ii) organizes and offers such covered fund, and proposes to change those limitations into an outright prohibition of "covered transactions" between such banking entity and covered fund (this prohibition is often referred to as Super 23A). The Proposed Rules would also require that all permitted transactions be on market terms if they are between a banking entity and any covered fund (i) organized and offered by such banking entity or (ii) for which the banking entity acts, directly or indirectly, as the sponsor, investment advisor, investment manager or commodity trading advisor. Under the Federal Reserve Act, covered transactions broadly include, among other things, the following activities between a member bank and its affiliates: (i) a loan or extension of credit to the affiliate, including a purchase of assets subject to an agreement to repurchase; (ii) the acceptance of securities or other debt obligations issued by the affiliate as collateral security for a loan; (iii) the issuance of a guarantee, acceptance, or letter of credit on behalf of the affiliate; and (iv) a derivative transaction, to the extent the transaction causes a member bank to have a credit exposure to the affiliate. One potential result of Super 23A being discussed among securitization participants is that issuers which historically have not been affiliates of banking entities, such as ABCP issuers, would be deemed to be affiliates under the Proposed Rules and so become subject to the prohibition on covered transactions and no longer able to rely on the liquidity and credit enhancement typically provided by the sponsoring banking entity. This prohibition on covered transactions, and the prohibition on the ownership and sponsorship of covered funds by banking entities, unless an exemption is available, may result in the elimination of ABCP programs in their current form. ABS issuers such as auto finance companies would lose access to amortizing term and revolving warehouse funding facilities provided by ABCP programs. More clarity regarding how the Agencies intend Super 23A to work is required to be able to confirm how Super 23A will directly and indirectly impact ABS issuers. Without such additional clarity, Super 23A could act as an expansion of the prohibition on material conflicts of interest in ABS transactions contained in Section 621 of the Dodd-Frank Act by prohibiting covered transactions even when there is no material conflict of interest. www.allenovery.com 7
Conclusion Although the intent of Section 619 is to include within the scope of covered funds only hedge funds and private equity funds, the fact that Section 619 references Sections 3(c)(1) and 3(c)(7) will cause many ABS issuers to fall within the definition of "covered fund." As discussed above, the loan securitization exemption provided in the Proposed Rules has been narrowly crafted and may not be available to many standard securitization products. During the comment period, securitization participants should focus on how the Proposed Rules can be revised to fully utilize and clearly reflect Section 619's provision that nothing in that section should be construed as limiting or restricting the ability of banking entities to sell or securitize loans in a manner otherwise permitted by law. www.allenovery.com 8
What's in a Name? The Volcker Rule's Impact on ABS Issuers that are Covered Funds Key Contacts If you require advice on any of the matters raised in this document, please call any of our partners or your usual contact at Allen & Overy. John Hwang Senior Counsel Securitization and Structured Finance Tel +1 212 610 6395 john.hwang@allenovery.com Lawton Camp Partner Securitization and Structured Finance Douglas Landy Partner Financial Services Regulatory Tel +1 212 610 6405 douglas.landy@allenovery.com Tel +1 212 610 6309 lawton.camp@allenovery.com www.allenovery.com 9
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